For decades, analysts have watched options trading patterns to try to divine market sentiment. By comparing the trading volume in call options to the volume of put options, they can gauge levels of bullishness or bearishness, and try to time the market accordingly.

These days there's a more nuanced way to take the market's temperature. The ISE Sentiment Index (ISEE), reported daily by the International Securities Exchange from its options transactions, allows analysts to drill down to the transactions that are most reflective of the sentiment of option speculators. The ISEE index measures only "opening long option transactions" by its customers, so this metric excludes option trades initiated by sellers or by the firms and market makers who are responsible for a lot of hedging and other complex strategies. Using only customers' opening long positions (in other words, customer orders to buy calls or buy puts) gives us the clearest picture of investor sentiment.

The ISE Sentiment Index is calculated as a daily ratio of call option volume to put option volume. Call options, of course, increase in value when the underlying stock's price rises, while puts gain value when the price falls. Therefore, this ISEE calculation is a ratio of bullish bets to bearish bets. At Schaeffer's Research we use a version of the ISE Sentiment Index that excludes indexes and exchange-traded funds (ETFs) and focuses only on equity option volume.

Since January 2007, the 50-day moving average of the ISEE equity call/put ratio has averaged about 180, which means equity option traders typically buy 180 calls for every 100 puts they purchase. The consistently higher proportion of option buying activity on the call side is in line with investor behavior—the tendency of investors to have bullish rather than bearish views on individual stocks, particularly when it comes to translating their views into action. And when investors are cautious on the overall market (as they have been in recent years), their tendency has been to allocate more of their portfolios to fixed income and cash rather than to actively bet on a market decline. In addition, buying puts on the various index and sector ETFs such as the
SPDR S&P 500 Trust spy -0.8739495798319328%SPDR S&P 500 ETF TrustU.S.: NYSE Arca206.43
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-0.0999999999999943-0.048442571331686286%
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(ticker: SPY) and, more recently, buying calls on the CBOE Volatility Index (VIX), have become the vehicles of choice for investors aiming to protect their stock portfolios from a market decline.

But at times, seemingly aberrant trading behavior reflected by the ISEE equity call/put ratio can offer a clue to the future direction of the stock market. And I'd suggest we are seeing increasingly unusual behavior by options traders as we move further into 2013. For example, the current reading for the ISEE equity call/put ratio is about 160 (160 calls purchased for every 100 puts purchased), which is 20 points below its normal level. This indicates options traders have been slow to embrace the bullish case for the market. Since the S&P has gained 14% over the past 12 months, is off to a strong start in 2013 and is trading near its highest levels since early 2008, you would expect options traders to boost their equity call buying and dampen their equity put buying more than we are seeing.

By way of comparison, as the market rallied into 2011 the ISEE equity call/put ratio entered the year at 220 (220 calls purchased for every 100 puts) and peaked in the first quarter of 2011 just shy of 240. So option buyers were a lot more enthusiastic two years ago than they are now, and they were similarly giddy in the third quarter of 2007, when the ISEE call/put ratio peaked at 220 just ahead of a major market peak.

Does this lack of enthusiasm by equity call option buyers (and persistence among equity put option buyers), despite clear evidence of strength in the stock market, guarantee a bullish market environment in 2013? There are no guarantees using any technical analysis tools. But an ISEE call/put ratio of 160 in the context of past peaks in the 220-240 range certainly indicates room for call buyers, and stock investors in general, to become much more enthusiastic. And the natural accompaniment to such a boost in investor optimism would be a swing in the flow of investor funds back to the stock market, a swing that could be particularly robust given the intensity of the flows out of stocks in recent years. And this would all add up to higher stock prices ahead.